Expected Utility Theory

Definition

Expected utility theory is a framework used to understand how individuals make decisions under uncertainty by evaluating the expected outcomes based on their preferences. This theory posits that people choose among risky or uncertain options by maximizing their expected utility rather than just considering the potential outcomes. This concept is significant in understanding decision-making processes, particularly in contexts like social insurance and behavioral economics.

5 Must Know Facts For Your Next Test

1. Expected utility theory assumes that individuals evaluate risky options by calculating the weighted average of possible outcomes, using probabilities to weigh each outcome's utility.
2. The theory contrasts with the notion of expected value, which focuses purely on the average outcome without accounting for individual risk preferences.
3. In social insurance contexts, expected utility theory helps explain why individuals may opt for insurance against risks, as they perceive higher utility from reduced uncertainty.
4. Critics of expected utility theory point out that real-world decisions often deviate from its predictions due to biases and heuristics, leading to alternative theories like prospect theory.
5. The concept of expected utility has widespread applications, influencing fields such as finance, health economics, and public policy, shaping how risks are assessed and managed.

Review Questions

• How does expected utility theory explain the decision-making process regarding social insurance?
  • Expected utility theory suggests that individuals evaluate the potential risks and benefits of social insurance by calculating the expected utility from different scenarios. When faced with uncertainty about future income or health risks, people tend to opt for insurance because it increases their overall utility by reducing the financial burden of adverse events. Thus, social insurance becomes attractive as it aligns with individuals' preference for security and risk aversion.
• Compare and contrast expected utility theory with prospect theory in the context of decision-making under risk.
  • Expected utility theory operates under the assumption that individuals make rational choices to maximize their expected utility based on probabilities and outcomes. In contrast, prospect theory highlights how real-world decision-making often involves cognitive biases, where people tend to weigh potential losses more heavily than equivalent gains. This difference indicates that while expected utility theory provides a theoretical model for rational behavior, prospect theory captures actual human behavior more accurately in uncertain situations.
• Evaluate how bounded rationality challenges the assumptions of expected utility theory in real-life decision-making scenarios.
  • Bounded rationality suggests that individuals' decision-making processes are limited by cognitive constraints, access to information, and time restrictions. This challenges the assumptions of expected utility theory, which posits that individuals have complete information and can calculate expected utilities perfectly. In reality, people often rely on heuristics or simplified models when making decisions under uncertainty, leading to choices that may not align with maximizing expected utility. This gap between theoretical expectations and actual behavior has significant implications for understanding economic choices in various settings.

Related terms

Risk Aversion: A preference for certainty over uncertainty, where individuals prefer outcomes with lower risk even if they have lower expected returns.

Utility Function: A mathematical representation of an individual's preferences, assigning a numerical value to each outcome based on its desirability.

Prospect Theory: A behavioral economic theory that describes how people make decisions based on potential gains and losses, highlighting that losses are often felt more acutely than gains.